Firms in Our Macroeconomy

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DEBATES IN MACRO-ECONOMICS OVER THE ROLE AND EFFECTS OF GOVERNMENT

CHAPTER

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ECONOMICS

Roger A. Arnold • Thirteenth Edition

(1 of 2)

18-1 Macroeconomics and Government: The Debate

18-2 Tax Cuts, Tax Revenue, and Budget Deficits

18-3 The Economy: Self-Regulating or Not?

18-4 More Government Spending or a Cut in Taxes: Which Gives a Bigger Bang for the Buck?

18-5 More Government Spending or a Cut in Taxes: The Size and Scope of Government

(2 of 2)

18-6 The Degree of Crowding Out

18-7 The Politics of Government Spending

18-8 Monetary Policy: Rules Versus Discretion

18-9 Bailouts

18-10 Demand-Side and Supply-Side Views of the Economy and Government Tools for Changing Real GDP

18-1 Macroeconomics and Government: The Debate (1 of 3)

Macroeconomists agree on some things, but if you ask them how sensitive investment is likely to be to a change in the interest rate in the current economic environment, not all of them are likely to give you the same answer

Elasticity of Investment: A measure of the responsiveness of investment to changes in the interest rate

Some might say that investment is likely to change a lot; the elasticity of investment is likely to be high

Others might disagree and argue that investment will not change much (or at all)

This is an empirical issue; how much will it change?

18-1 Macroeconomics and Government: The Debate (2 of 3)

Other empirical issues that economists might not agree on are:

How much will aggregate demand rise if government increases its spending? Or

How flexible or inflexible are wages in the current economic environment?

In addition, economists also disagree over the role government should play in the economy, given their understanding of how the economy works; if 3 economists reach the same diagnosis, they will not necessarily recommend the same government policies

One may say, “Do nothing;” one may recommend X, another, Z

18-1 Macroeconomics and Government: The Debate (3 of 3)

Most first-time students of macroeconomics want explanations for various macroeconomic phenomena, and to learn the right approach to deal with them; like doctors, they ask, “What is wrong with the economy and what is the best policy to get it well?” But answers in economics are not so clear cut

President Harry S. Truman once said, “Give me a one-handed economist. All my economists say “On the one hand, and then on the other hand.”

Although at this point you might be content with a “one-handed” answer, you wouldn’t be getting an accurate picture; you need to hear some of the debates in macroeconomics

18-2 Tax Cuts, Tax Revenue, and Budget Deficits (1 of 2)

Suppose the federal government is running a budget deficit; government spending is greater than tax revenue

To reduce the size of the deficit, some economists propose income tax cuts

Others argue that income tax cuts will not lead to a smaller deficit

The issue is whether tax cuts will or will not raise tax revenue

The first group argues:

1. If income tax rates are cut, people will choose to work and produce more

2. As a result, they will generate more income, and the tax base will rise

3. If the tax base rises by more than the tax rates are cut, tax revenue will rise

4. More tax revenue will end up reducing the size of the budget deficit

18-2 Tax Cuts, Tax Revenue, and Budget Deficits (2 of 2)

Another group of economists challenges the “if” part of assumption 3; they argue that the tax base is not likely to rise by more than tax rates are cut, so result 4 will be less tax revenue and therefore a bigger budget deficit

Recall that Tax revenues = Tax base x (average) Tax Rate

Almost all economists agree that if the tax rate is cut, the tax base will rise, but not all agree as to how much it will rise

Economist A: Tax cutes will raise tax revenue; increased tax revenue will decrease the size of the budget deficit

Economist B: Tax cuts will lower tax revenue; decreased tax revenue will increase the size of the budget deficit

18-3 The Economy: Self-Regulating or Not? (1 of 1)

One major debate in macroeconomics focuses on whether the economy is self-regulating

For example, if an economy is in a recessionary gap, can it move itself into long-run equilibrium?

Economist A: Wages are flexible, so if the economy is in a recessionary gap, it will soon remove itself from the gap. Government doesn’t have to do anything

Economist B: Wages are inflexible downward, so if the economy is in a recessionary gap, it may be stuck there. The best course of action is for the federal government to implement expansionary fiscal policy or for the Fed to implement expansionary monetary policy to remove the economy from the recessionary gap

18-4 More Government Spending or a Cut in Taxes: Which Gives a Bigger Bang for the Buck? (1 of 1)

Government Spending Multiplier: The number that, when multiplied by the change in government spending, gives us the change in total spending (and, if prices are constant, the change in Real GDP)

Tax Multiplier: The number that, when multiplied by the change in taxes, gives us the change in total spending (and if prices are constant, the change in Real GDP

Economist A: The economy needs expansionary fiscal policy to remove it from a recessionary gap; government should either raise its spending or cut taxes. I believe that the government spending multiplier is larger than the tax multiplier, so suggest that government increase its spending

Economist B: The economy needs expansionary fiscal policy to remove it from a recessionary gap. Government should either raise its spending or cut taxes. I believe the tax multiplier is larger than the government spending multiplier, so I suggest government cut taxes

18-5 More Government Spending or a Cut in Taxes? The Size & Scope of Government(1 of 1)

The size of government relates to the resources over which it has command; the scope of government relates to what and how many things government does

Both a rise in government purchases and a cut in taxes are expansionary fiscal policy measures, but they don’t have the same impact on the size and scope of government

Economist A: Expansionary fiscal policy is needed to raise aggregate demand and remove the economy from a recessionary gap. The choice of fiscal policy measures is between more government spending and a cut in taxes. Because I am in favor of bigger government, I choose more government spending

Economist B: Expansionary fiscal policy is needed to raise aggregate demand and remove the economy from a recessionary gap. The choice of fiscal policy measures is between more government spending and a cut in taxes. Because I am in favor of smaller government, I choose a cut in taxes

18-6 The Degree of Crowding Out (1 of 1)

Suppose 10 of 10 economists agree that the economy is in a recessionary gap; 7 propose an expansionary fiscal policy measure in the form of greater government spending to remove the economy from the recessionary gap; 3 oppose this action

Economist A: A rise in government purchases will increase aggregate demand and remove the economy from the recessionary gap because little or no crowding out will occur; a rise in government purchases will end up increasing the number of jobs in the economy

Economist B: A rise in government purchases will not increase aggregate demand and remove the economy from the recessionary gap because of complete (or nearly complete) crowding out

18-7 The Politics of Government Spending (1 of 1)

The fiscal policy that emerges in a political vacuum is likely different from that created in a political process; but if all agree on government spending, does it matter how the money is spent?

Economist A: An expansionary fiscal policy measure is needed to increase Real GDP, lower the unemployment rate, and so on. I propose $100 billion more in government spending. It doesn’t really matter what the $100 billion is spent on; the important thing is that the money be spent

Economist B: An expansionary fiscal policy measure is needed to increase Real GDP, lower the unemployment rate, and so on. Ideally, the economy needs $100 billion more in government spending. But how the money is spent will be determined by Congress, and Congress is likely to be motivated by political interests. Further, not all spending is the same. Some spending is better for the economy than other spending. I think much of the spending that we will get from Congress will be motivated by politics instead of economics, and sometimes, spending motivated by politics will be of little help in turning the economy around. In the end, I have my doubts as to how effective an increase in government spending will be in aiding the economy

18-8 Monetary Policy: Rules versus Discretion (1 of 1)

With regard to the creation of monetary policy, some economists argue in favor of a rules-based system (The Taylor Rule, or some fixed rate); others argue in favor of discretion for the Fed, saying it needs flexibility to create the best monetary policy possible given the circumstances

Economist A: A monetary rule is preferred to a discretionary Fed; the former is more likely to bring about stable prices, low unemployment, and so on; in addition, a monetary rule removes monetary policy from politics

Economist B: A discretionary Fed is preferred to a monetary rule; the Fed needs the flexibility to tailor monetary policy to the existing circumstances

18-9 Bailouts (1 of 2)

Not all economists agree on whether government should bail out companies that are experiencing financial problems

Economist A: In a perfect world, bailing out companies is not a good idea. But Company X is a large company, and if it goes out of business, that will adversely affect hundreds of thousands of persons. Bailing out the company is better than letting it fail; we lose more by letting the company fail than by saving it. Some companies are simply too big to be allowed to fail. Their failure is like an earthquake, adversely affecting all the people around them. To save the innocent, sometimes you have to save the not so innocent

18-9 Bailouts (2 of 2)

Not all economists agree on whether government should bail out companies that are experiencing financial problems (cont)

Economist B: Who is “we” when you say, “We lose more by letting the company fail than by saving it?” Some persons gain by having the company bailed out, and others lose. Furthermore, if we continue to tell companies that the federal government will be there if they fail, we simply create an environment in which we privatize gains (the companies keep the gains if there are any) and socialize the costs (spread the costs among millions of taxpayers if the companies end up in financial problems). In the end, this policy will lead to more companies that “need” to be bailed out

18-10 Demand-Side and Supply-Side Views of the Economy and Government Tools for Changing Real GDP (1 of 2)

Much of our discussion of macroeconomics has been in terms of aggregate demand and aggregate supply; the AD curve was always represented as downward sloping, while the AS curve was shown as vertical or upward sloping (Exhibit 1)

Depending on your view of whether the real aggregate supply curve is vertical or upward sloping, how would you respond to this question:

Assuming the objective is to raise Real GDP, would it be preferable for government to try to increase aggregate demand or aggregate supply?

18-10 Demand-Side and Supply-Side Views of the Economy and Government Tools for Changing Real GDP (2 of 2)

Economist A: The aggregate supply curve is vertical. Therefore, government actions designed to change aggregate demand in the economy will not lead to changes in Real GDP. Changes in Real GDP come from the supply side of the economy, not the demand side. Government has fewer tools (demand-side fiscal policy and monetary policy won’t work) that are capable of raising Real GDP than the economist who sees the AS curve as upward sloping believes

Economist B: The aggregate supply curve is upward sloping (in the short run). Government actions designed to change aggregate demand in the economy will lead to change sin Real GDP (at least in the short run). Changes in Real GDP (in the short run) can come from either the demand side or the supply side of the economy. Government has more tools (demand-side fiscal and monetary policy do work) that are capable of raising Real GDP than the economist who sees the AS curve as vertical believes